Maria’s Note: Maria Bonaventura here, Rogue Economics’ senior managing editor. Today, we hand the reins over to one of Nomi’s regular contributing editors, Eoin Treacy. Eoin is a career analyst, writer, strategist, commentator, and lecturer. He’s known around the world for his knowledge of asset classes, sectors, and thematic investing.

Today, Eoin reads between the lines of the Federal Reserve’s last policy meeting… and shows us how we can get one step ahead of the Fed.

Capital is both global and mobile. It flows to the most attractive assets in the world. Money flows are part of a tapestry of events that create the markets we seek to profit from.

That’s why we spend so much time monitoring money flows around the world. They form the basis for the new normal Nomi has been writing to you about, where the abundant money created by central banks – also called liquidity – is driving markets higher.

It’s a symptom of the growing disconnect Nomi has identified between the markets and the real economy. And as she told us last week, that liquidity is here to stay.

Now, there’s a lot of talk about America’s central bank, the Federal Reserve, raising interest rates and cutting back on its money-creation. Many investors fear this could spell doom for stocks.

Today, I’ll show you why those fears are misplaced, along with the best step investors can take today. But first, you should understand the Fed’s central role in the markets’ ups and downs…

How the Federal Reserve Regulates the Economy

Last week, the Federal Reserve released the minutes of its December meeting.

One big announcement – buried on page 4 – grabbed my attention. It gets to the heart of the question whether global liquidity is expanding or contracting:

Participants had an initial discussion about the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate from the [effective lower bound] ELB.

They also discussed how this relative timing might differ from the previous experience, in which balance sheet runoff commenced almost two years after policy rate liftoff when the normalization of the federal funds rate was judged to be well under way.

Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.

Let me unpack that Fed-speak a bit…

I’m sure you’ve heard the term quantitative easing (QE). This is when the Federal Reserve substantially expands its balance sheet by buying Treasury bonds and adding them to it.

It does this to support asset prices and the economy. And when the economy is strong enough again, it “tapers” its bond purchases.

A balance sheet runoff is the opposite of quantitative easing. The Fed reduces its balance sheet. Often, it does this by selling bonds. But with a “runoff,” it simply deletes bonds from its balance sheet as they expire. This reduces its total assets at a predictable pace (bonds have set expiry dates).

This is referred to as quantitative tightening (QT). The Fed does this when it is worried about the economy overheating and inflation – as it is right now. So it’s no surprise to see talk of a balance sheet runoff.

What Happened the Last Time the Fed Tightened?

The last time the Fed engaged in quantitative tightening was at the end of 2017.

2017 was one of the least volatile years for stock market returns in history. Stocks had been rallying for eight years. And in 2017, the market had responded very positively to the Trump tax cuts. The S&P 500 ended the year up 21.8%.

The Fed was worried about the market overheating. So between the end of 2017 and the end of 2018, it reduced the size of its balance sheet by more than 8%.

The three main effects of this quantitative tightening program in 2018 were higher Treasury bond yields, a strong U.S. dollar, and a more volatile stock market.

Five-year Treasury yields increased by 0.75% in 2018. The U.S. Dollar Index traded up from a low of 88 to a peak of 97.

And the Volatility Index (VIX) – a measure of volatility in the market – spiked from about 10 to 30 on two occasions. A spike like that is indicative of higher volatility, signaling investor fear and uncertainty.

The Relationship Between the Fed and the Stock Market

2018 saw two big market pullbacks. The Fed was at the center of both.

The first 10% drop on the S&P 500 occurred in February, right after Jerome Powell was installed as Fed chief. That’s not unusual. The market tends to test the new Fed chairman by selling off.

Powell committed to doing nothing too drastic. Stocks recovered from the February low and traded out to new highs in August.

The second setback began in October. It followed a statement by Powell that interest rate hikes and quantitative tightening were on “automatic pilot.” The market swiftly showed its displeasure with a 20% plunge in the S&P 500.

Chastened, Powell made soothing statements, saying the Fed would be “patient” about raising rates any further.

The S&P 500 recovered somewhat, but still ended 2018 down nearly 7%.

Why Is the Fed Talking About Quantitative Tightening Now?

Today, the market looks similar to late 2017…

As I told you last Tuesday, the Dow and the S&P 500 have both experienced huge upticks from their March 2020 pandemic lows.

And now, there is also rising inflation to worry about. At last count, it was at 6.8%, the highest level since 1982.

In response to an overheating economy, last November, the Fed started to “taper” the bond purchasing (QE) program it had introduced the previous year to support the economy during the pandemic.

The 5-Year Treasury yield has gone up by 0.6% since October… And after trading in the low-90s in the middle of the year, the U.S. Dollar Index is currently at around 96… The VIX is currently reading around 20, up from the mid-teens at the start of the year.

Now, it’s no coincidence that bond yields are trending higher. Any reduction in the Fed’s bond purchases removes a major source of the demand from the bond market, so prices fall. And bond yields move inversely to price.

The recent rally in the U.S. Dollar Index is also no surprise. Lower Fed bond purchases also reduces the number of dollars in circulation.

But this time, these effects have already started before the Fed has even officially started QT.

And the markets reacted strongly to the Fed’s balance sheet runoff talk. The Fed released its December meeting minutes on Wednesday afternoon. By the following morning, the S&P 500 had dropped by more than 2%.

Keep Your Powder Dry, But Be Ready to Fire

Now, as I said last week, I don’t believe we are anywhere close to a recession. However, I do expect 2022 to deliver a good-sized wobble, likely up to 10%, sometime in the first quarter.

That will present a very attractive buying opportunity for stocks.

But it might be short-lived. If we see a pullback of that magnitude, I expect the Federal Reserve to begin walking back its hawkish statements, just like it did at the end of 2018.

I wouldn’t be surprised if it announced one interest rate hike and then called it quits.

If that happens, the stock market will rebound strongly because right now, investors are expecting at least three interest rate hikes this year from the Fed.

So for now, keep your powder dry… but put together your wish list of stocks you’d like to add to your portfolio.

Your chance to swoop in and pick them up at a discount could come soon…


Eoin Treacy
Contributing Editor, Inside Wall Street with Nomi Prins

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